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Reslicing the Corporate Pie

November 27, 2007

Anyone who follows financial news is likely to see a growing number of stories about corporations that are buying back their stock. What’s missing from the individual stories is the larger picture: the large number of buybacks is reshaping the U.S. economy by rapidly shifting hundreds of billions of dollars from unproductive uses to new ventures.

This is an important part of the process by which the U.S. economy renews itself through the shrinkage and death of old companies and the rise of innovative new ones, says David Ikenberry, chair of the Department of Finance.

The U.S. has gone through this cycle of death and renewal many times. Perhaps the best example was the shift from the horse and buggy era to the age of automobiles. It takes a great deal of money for such shifts to take place. In the current economy, one of the sources of this capital is stock buybacks, says Ikenberry, who has studied the buyback phenomena extensively.

For instance, data calculated by Ikenberry and others showed that announced buybacks exceeded threequarters of a trillion dollars between 1995 and 1999, and the current buyback boom appears much bigger. Between mid-June and mid-July of this year alone, corporations announced 81 buybacks totaling more than $65 billion, according to data compiled by The Online Investor.

Moving Money

When a company buys back its own stock, it shifts cash from corporate coffers to the stockholders who sold their shares. The stockholders in turn look for new investments, and some of the cash winds up financing the next generation of innovative companies.

Stock buybacks are usually explained in the press as a mechanism that corporate management can use to increase earnings per share. The phenomenon of recycling capital from buybacks into the creation of new companies has been largely overlooked by the mainstream media.

“If you read the popular press, they largely trivialize this,” says Ikenberry. “Instead, the press turns it into an earnings-per-share manipulation device. That misses the point. In place of that, this notion of recycling capital seems more appropriate. You think about the dot.com boom. Where did the capital for all that expansion come from? It came from this recycled capital.”

Of course, not every investment of buyback cash works out. The dot.com boom was littered with failures, just as the early years of the automobile age were marked by failed car companies. But enough succeed to change the economy. “We put a lot of spaghetti up on the wall, and some of it stuck,” says Ikenberry. “Google is now one of the largest companies in the world.”

What Triggers Buybacks?

Buybacks have an impact because they add up to a lot of money, as Ikenberry observed in a journal article that summarized stock repurchase research done by himself and other economists. The piece, entitled “What Do We Know About Stock Repurchases?” appeared in the Spring 2000 edition of the Journal of Applied Corporate Finance. It was coauthored by Gustavo Grullon when both authors were at Rice University.

The paper also observed that in 1998, for the first time, corporations distributed more cash to investors through share repurchases than through cash dividends. And the trend toward buybacks hasn’t slowed.

“Buybacks are going at a breakneck pace,” Ikenberry says. “It appears to be much bigger than in the period from 1995 through 1999.”

There are two reasons why the pace of buybacks could get particularly torrid: many corporations are sitting on cash hoards from strong corporate profits, and many stocks are cheap. When corporations have more money than they need for their operations, buybacks are one way to use it. And when stocks are cheap, it costs less for companies to buy back their own shares.

Why might stocks be cheap now and in the immediate future? One reason is that the fallout of the ongoing subprime mortgage debacle has shaken the stock market. Shockwaves from the growing number of defaults on mortgages issued to sub-prime borrowers has hit the stocks of mortgage companies, home builders, and Wall Street investment firms.

But those tremors have shaken other stocks as well, spurring a broad market decline in stock prices. Falling stock prices may give investors fits, but they also encourage companies to buy back their stock because it’s cheaper to do so when prices are down. “We’re going to see an avalanche of buyback announcements,” Ikenberry predicts.

If the stock price downturn continues and triggers more buyback announcements, it would follow historical precedent. Buybacks rose after the big market crash of 1987, the mini-market crash of 1991, and the market disruption that followed the attack on the World Trade Center in 2001.

But in the long run, the sub-prime mortgage debacle could have the reverse effect on buyback programs if it leads to an economic slowdown that depresses corporate profits. If profits are down, corporations would have less money to spend on stock repurchases. In that case, Ikenberry says, fewer companies would complete buyback programs already announced, and you would see fewer announcements of new buyback programs.

Why would troubles in sub-prime lending damage the economy and corporate profits? First, U.S. home prices fell 3.2 percent in the second quarter of 2007. That was the sharpest rate of decline since Standard & Poor’s created a nationwide housing price index in 1987. As prices have fallen, it’s become harder for consumers to borrow against their homes to finance bigticket purchases, such as cars and vacations. Much of the current economic expansion has been attributed to consumer spending, and home equity loans have helped to fuel that spending. If consumers stop spending because they can’t borrow against their homes, corporate profits would likely drop, along with the size of cash hoards that are used to buy back stock.

In addition, many homeowners are either losing their homes or on the brink of doing so. “If my mortgage is in trouble, the last thing I will do is buy a new car,” says Ikenberry.

Pull Backs on Buybacks

Generally, companies have been reliable about following through on announced buybacks, though they usually hedge buyback announcements with language that allows a quick exit. For instance, they say they “intend” to follow through, and they don’t say how quickly they will do it.

Finance professor Michael Weisbach studied the buyback phenomenon about a decade ago and found companies completed announced buyback programs about three quarters of the time. But sometimes, companies never repurchased any shares after making a buyback announcement or failed to finish buyback programs they had already started.

In his study, there were a number of reasons why that happened, Weisbach found. For example, “If the stock price went up after they made the announcement, it no longer made sense to do the buyback,” says Weisbach. “Let’s say you announce you’ll buy back your stock because it’s trading at $25 a share and you think it’s worth $30 a share. If the price goes up to $30, then the reason for buying it back is no longer there.”

There were three other reasons companies failed to follow through, he says. “They had a shock to their cash flow, they needed the money elsewhere, or they discovered a better use for it than buying back their stock.”

That’s where the sub-prime lending crisis represents a potential threat to buybacks. If sub-prime problems pull down the larger economy, corporations might quickly find they need the money elsewhere.

Repurchase, Return, Recycle

In the meantime, stock repurchases are churning along and helping to fuel the transformation of the U.S. economy-and in the process generating jobs to replace those lost to foreign competition, automation, and corporate downsizing.

And some of the money being recycled through buyback programs comes from companies that are part of an industry in decline.

“If a company is in a declining industry, that may be the best time to give the money back through stock repurchases,” says Ikenberry. “Rather than put the money into buggy whips, they ought to give the money back to shareholders. Then the capital that’s liberated from declining business can be recycled and put back into biotech or whatever the great new uses are.”

Sidebar: 2 Views on Stock Repurchases

There are two ways to look at stock repurchase programs. One way is to view them from the perspective of corporate management. The other is to look at how buybacks impact the economy.

Management uses buybacks to “signal” their optimism about their firm’s future and to indicate that they think their stock is undervalued in the marketplace. Managers also buy back stock to boost reported earnings per share, though economists say that this justification amounts to “an economic sleight of hand.”

But the bigger picture focuses on how buybacks impact the larger economy. Finance professor David Ikenberry explained it this way in a paper he coauthored on the subject-“What Do We Know About Stock Repurchases?” from the Spring 2000 issue of the Journal of Applied Corporate Finance.

“A central premise of how capital is allocated in a free economy is that corporations should consider returning capital to shareholders when they have run out of value-added investments. Shareholders are then free to reallocate this capital to more productive uses. The reason for this is that shareholders have a broader view of economy-wide opportunities.

“In short, one important reason for share repurchases has to do with the natural birth and death process of companies in a capitalist system. Although corporate managers appear to use stock repurchases simply to address their own perceived undervaluation problems, the financial markets at large effectively use repurchases as a principal means of liberating capital from a moribund economic sector so that it can be channeled into more promising ones.”

In the era before stock buybacks took off, corporations primarily returned excess cash to stockholders through dividends. But the tax laws now work against that because dividends are taxed as ordinary income. For individuals in high tax brackets, the tax bite on ordinary income can be quite steep. By contrast, any profits from stock buybacks are treated as capital gains. The top tax rate for capital gains is lower than the top tax rate for ordinary income. In addition, stockholders who don’t want to incur any additional tax bill can simply opt not to sell their shares.

One reason for the surge in buybacks was a change in the regulatory climate.Before 1982, there were no regulatory guidelines for buybacks. Many firms avoided repurchases apparently because they were afraid they would be accused of manipulating stock prices if they did so.

In 1982, the Securities & Exchange Commission issued rule 10b-18, the first rule that set out guidelines for stock repurchases. This reduced the chance that a company would run into legal trouble if it bought back its stock. After rule 10b-18 took effect, the number of share buybacks surged. By 1998, for the first time, the total amount of cash spent on stock buybacks by U.S. companies was greater than the amount of cash that companies paid out in dividends.

The stock buyback movement, which began in the United States, has gone global, spreading to such countries as Canada, the United Kingdom, Japan, and Germany.

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